Jeremy Siegel and Jeremy Schwartz: The Great American Bond Bubble -... http://online.wsj.com/article/SB10001424052748704407804575425384...

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OPINION AUGUST 18, 2010

If 10-year interest rates, which are now 2.8%, rise to 4% as they did last spring, bondholders will suffer a
capital loss more than three times the current yield.
By JEREMY SIEGEL AND JEREMY SCHWART Z

Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology
mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable:
Most of these highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a
decade ago.

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds,
particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into
bond funds, and Treasury bonds have been among their favorites. The Investment Company Institute reports
that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds
have seen a massive $559 billion of inflows.

We believe what is happening today is the flip side of what happened in 2000. Just as investors were too
enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.

The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities
(TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago,
is currently selling at more than 100 times its projected payout.

Shorter-term Treasury bonds are yielding even less. The interest

rate on standard noninflation-adjusted Treasury bonds due in
four years has fallen to 1%, or 100 times its payout. Inflation-
adjusted bonds for the next four years have a negative real yield.
This means that the purchasing power of this investment will
fall, even if all coupons paid on the bond are reinvested. To boot,
investors must pay taxes at the highest marginal tax rate every
year on the inflationary increase in the principal on inflation-
View Full Image
protected bonds—even though that increase is not received as
Martin Kozlowski cash and will not be paid until the bond reaches maturity.

Today the purveyors of pessimism speak of the fierce headwinds

against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging
data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued
much of that debt to pennies on the dollar.

This suggests that if the household sector owes what the market believes that debt is worth, then effective debt
ratios are much lower. On the other hand, if households do repay most of that debt, then the financial sector will

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Jeremy Siegel and Jeremy Schwartz: The Great American Bond Bubble -... http://online.wsj.com/article/SB10001424052748704407804575425384...

be able to write-up hundreds of billions of dollars in loans and mortgages that were marked down, resulting in
extraordinary returns. In either scenario, we believe U.S. economic growth is likely to accelerate.

Furthermore, economists generally agree that the most

More
important determinant for long-term economic growth is
Investors Flock to Debt Tied to Consumer
Loans
productivity, not consumer demand. Despite the subpar
Complete Coverage: Bonds
productivity growth reported for the last quarter, the latest
year-over-year productivity growth of 3.9% is almost twice the
Market Data Center: Bonds, Rates & Credit
Ratings long-term average. For the first two quarters of this year
productivity growth, at over 6%, was the highest since the 1960s.

From our perspective, the safest bet for investors looking for income and inflation protection may not be bonds.
Rather, stocks, particularly stocks paying high dividends, may offer investors a more attractive income and
inflation protection than bonds over the coming decade.

Yes, we can hear the catcalls now. Stock returns calculated off the broad-based indexes have been horrendous
over the last decade. In 2009, the percentage decline in aggregate dividends was the largest since the Great
Depression. But remember the last decade began at the peak of the technology bubble.

Those who bought "value" stocks during the tech bubble—stocks with good dividend yields and low price-
to-earnings ratios—have done much better. From December 1999 through July 2010, the Russell 3000 Value
Index returned 35% cumulatively while the Russell 3000 Index of all stocks still showed a loss.

Today, the 10 largest dividend payers in the U.S. are AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson
& Johnson, Verizon Communications, Phillip Morris International, Pfizer, General Electric and Merck. They
sport an average dividend yield of 4%, approximately three percentage points above the current yield on 10-year
TIPS and over one percentage point ahead of the yield on standard 10-year Treasury bonds. Their average price-
earnings ratio, based on 2010 estimated earnings, is 11.7, versus 13 for the S&P 500 Index. Furthermore, their
earnings this year (a year that hardly could be considered booming economically) are projected to cover their
dividend by more than 2 to 1.

Due to economic growth the dividends from stocks, in contrast with coupons from bonds, historically have
increased more than the rate of inflation. The average dividend income from a portfolio of S&P 500 Index stocks
grew at a rate of 5% per year since the index's inception in 1957, fully one percentage point ahead of inflation
over the period. That growth rate includes the disastrous dividend reductions that occurred in 2009, the worst
year for dividend cuts by far since the Great Depression.

Those who are now crowding into bonds and bond funds are courting disaster. The last time interest rates on
Treasury bonds were as low as they are today was in 1955. The subsequent 10-year annual return to bonds was
1.9%, or just slightly above inflation, and the 30-year annual return was 4.6% per year, less than the rate of
inflation.

Furthermore, the possibility of substantial capital losses on bonds looms large. If over the next year, 10-year
interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield.
If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there
any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous
government entitlement programs kick into gear?

With future government finances so precarious, private asset accumulation and dividend income must become
the major sources of retirement funding. At current interest rates, government bonds will not be the answer. One
hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now
true for government bonds.

Mr. Siegel is a professor of finance at the University of Pennsylvania's Wharton School and a senior adviser to
WisdomTree Inc. Mr. Schwartz is the director of research at WisdomTree Inc.

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